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Strategic Corporate Finance: Applications in Valuation and Capital Structure by Justin Pettit

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CHAPTER 11

Best Practices In Hedging

The high cost of fuel has helped drive airlines into bankruptcy. Sharp currency movements have had a dramatic impact on corporate results. For example, DaimlerChrysler reported that a favorable currency environment generated half of its second quarter 2003 earnings. U.S. dollar (USD) movement against the Euro, Yen, and Canadian dollar (CAD) have forced CEOs and CFOs to think more strategically about and to revisit antiquated risk management policies and practices. Increasingly, companies are examining exposures from multiple sources: mergers and acquisitions (M&A), foreign assets and liabilities, foreign sourced costs and profits, and existing hedge contracts.

Regardless of the details regarding how we define and quantify exposures, they are a large and growing factor in business models today. For example, global growth, global sourcing, and foreign direct investment often represent valuable opportunities. But they bring additional sovereign, currency, and interest rate risks. Though many companies attempt to modify sourcing or other operational changes to match their revenue and cost footprints more closely, operational constraints, competitive response, and strategic flexibility may require financial hedging where natural hedging is suboptimal.

As discussed in the prior chapter, mismatches in future sources and uses of cash represent true economic exposure. Hedging can reduce the responsiveness of cash flows to risk drivers such as rate fluctuations. ...

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